- Behavioral Economics
- L1. Rationality, Irrationality, and Rationalization
If economics is the study of how scarce resources are allocated given unlimited wants, behavioral economics may be said to focus more specifically on how scarce decision resources are allocated. Standard microeconomic modeling supposes that people make decisions with the sole purpose of making themselves better off. Behavioral economics often focuses on how people systematically deviate from the best possible decisions and what it will mean for the allocation of scarce resources. Behavioral economics is the study of how observed human behavior affects the allocation of scarce resources.
- L2. Transaction Utility and Consumer Pricing
Suppose you were in an upscale, yet unfamiliar, restaurant and while perusing the menu you come across your favorite dish. It sounds delicious, but it is very expensive. You convince yourself that it will be worth the price given the reputation of the restaurant: This will be something special. When the food arrives, it looks different from what you had expected. You taste it and are disappointed. The sauce that is integral to your preference for the food is all wrong. In fact, it is so bitter that it makes eating the food somewhat unpleasant. Nevertheless, you convince yourself to eat because you paid so much for the meal. Why should you let all that money go to waste?
- L3. Mental Accounting
Suppose you had a coupon for a free ice cream cone from a local ice cream parlor. While walking by the store on a particularly hot day, you decide to redeem your coupon. Leaving the store, you stroll down the street and accidently drop the cone on the ground, rendering the ice cream inedible. You are disappointed at first, but you achieve some comfort by reminding yourself that it was free to begin with. You reason that if you didn’t have to pay for it, it was no real loss. Alternatively, suppose you had been wanting to buy a new video game system. You had contemplated saving for the system, but knew you really needed to save your money for a new pair of eyeglasses. Your prescription had changed substantially and it was beginning to be difficult to do everyday things. One afternoon you check your mail and find that your grandmother has written you a check. It is just enough to purchase either the game system or the new glasses. After thinking about it for a minute or two you decide to purchase the video game system. What kind of a gift would glasses make, anyway?
- L4. Status Quo Bias and Default
Jill is a transfer student who arrived on campus several months ago, deciding to live off campus. When she was hungry on her first day after arriving, she walked around the street near her apartment, where dozens of restaurants were located. Each of the restaurants looked good, and eventually she decided simply to walk in the next one she came across. Since that time, she has tried some of the other restaurants nearby, and some are very good, but she most often eats at that same restaurant. It is not the nearest to her apartment, but nonetheless she considers it worth the walk. Consider also a person who is buying auto insurance for the first time, meeting with the insurance agent. The policies are rather complicated and involve making decisions regarding several different parameters (e.g., collision coverage, deductibles).
- L5. The Winner’s Curse and Auction Behavior
Consider Rick, who found a rare coin listed on an online auction website. The auction is to last two weeks. Rick is very familiar with coin collecting and has a very good idea of the coin’s value. He places a bid based upon the value he believes the coin holds when he discovers the auction, and is satisfied because his bid is the highest thus far. He then waits, checking the auction site daily to see if his bid is still the top. One day before the auction is to close, he notices that someone has outbid him by at least $10. Rick quickly responds by upping his bid by $20, only to discover that he is still being outbid. Thus he follows up with another increase of $30, obtaining the top bid and winning the coin. Rick is very satisfied to have won the auction, and he doesn’t seem to be bothered by paying almost $50 more for the coin than he thought it was worth.
- L6. Bracketing Decisions
Decision bracketing is closely related to hedonic editing or framing. However, hedonic editing and framing deal only with how people evaluate events (valuing them more or less), whereas choice bracketing deals directly with how the decisions themselves are made (which tradeoffs or variables are considered when making the choice). Choice bracketing has implications both for risky and riskless choice. However, discussing risky choice requires some review of rational choice under uncertainty, hence the placement of this chapter in the Information and Uncertainty section of the course. We review rational models of multiple decisions as well as the most widely accepted rational model of decision under risk: expected utility theory. This model is covered in greater detail in Chapter 9, including its axiomatic foundation (i.e., why we consider it rational).
- L7. Representativeness and Availability
Cornell University’s basketball team won the Ivy League championship in 2008, 2009, and 2010. Along the way the team set several team records for three-point shooting. In conversation, the basketball coach was asked about how he decides which players he will use in any particular game. He listed several key factors such as the particular matchups with the opposing team’s players, but he also mentioned the importance of putting in the guy who has been on a shooting streak in the last several games. When pressed, he admitted that there were several factors that could contribute to such a streak but felt that if in a single game a regularly good shooter was cold, he would sit him on the bench in favor of a player with lower average percentage shooting. In fact, many coaches, players, and fans feel they can quickly discern when a player is either on a streak or in a slump in terms of shooting.
- L8. Confirmation and Overconfidence
Throughout the last several years, the cry of political bias has been directed at the news media from nearly all quarters. Interestingly, though, one hears very different accusations from each quarter. In particular, when asked, a majority of political conservatives accuse the network news and major newspapers of a deep liberal bias. However, when one questions the most politically liberal, they claim that the same media display a conservative bias. If we consider both groups of people to be sincere, it appears that they have come to exactly opposite conclusions while viewing the exact same information. In fact, because of the supposed bias, many have chosen to obtain their news primarily from cable news outlets that seem much more open about their bent.
- L9. Decision under Risk and Uncertainty
People often face problems of decision under risk. In general, models of decision under risk consist of two-component models: a model of preferences over outcomes and a model of risk perception. Rational models of decision under risk depend heavily on the assumption that people understand the potential outcomes of any risky choice and the probability of each of those outcomes. In the previous chapters, we discussed several anomalies related to how people deal with probabilistic information. Behavioral models of risky choice generally base the component model of beliefs on behavior observed in experimental settings. For example, people seem to treat certainty in a very different way than probabilistic outcomes, an effect that might make exploding job offers more profitable for inferior firms. Or people may be reluctant to invest in the stock market despite higher average returns, opting for low-returning savings accounts. Interestingly, experimental observations of choice under risk sometimes contradict the common behaviors discussed in the previous chapters.
- L10. Prospect Theory and Decision under Risk or Uncertainty
On October 12, 2007, American investors celebrated a new high-water mark as the Dow Jones Industrial Average hit an all-time high of 14,093. Stocks were booming, and many people were buying. Home values had also increased substantially over the previous decade, producing substantial wealth for those who had invested in home ownership. Many had taken out large loans to buy up real estate as an investment, counting on continuing increases in home prices to produce value. With a large cohort of baby boomers preparing for retirement, many had built substantial wealth through stock and real estate investments and felt well prepared financially for a long and comfortable retirement. That’s when things started to go sour.
- L11. Disagreeing with Ourselves: Projection and Hindsight Biases
On March 19, 2003, President George W. Bush announced that the United States was invading Iraq. This followed months of protracted arguments to the American people and to the world that Iraq had a chemical and biological weapons program that was in violation of their 1991 cease-fire agreement with the United States. Iraq had committed several other blatant violations of the cease-fire agreement, including firing on U.S. airmen. Nonetheless, the Bush administration had set as the centerpiece of its argument for invasion the existence of a thriving chemical and biological weapons program that presented a threat to the region.
- L12. Naïve Procrastination
Procrastination, like the hot–cold empathy gap described in Chapter 11, can result in time inconsistent preferences. We might see others who went to work right away, look back on our actions, and consider that we have taken the wrong strategy. Firms interested in selling products can use customer procrastination to their own advantage through price discrimination or by charging customers for services or the option to take some action that they will never exercise. In some cases, finding last-minute tax preparation is more costly than early preparation. In others, people might pay in advance for flexible tickets that they never actually find the time to use. This chapter introduces the exponential model of time discounting, the most common in economic models, and the quasi-hyperbolic model of time discounting. The latter has become one of the primary workhorses of behavioral economics. This model is expanded on in Chapter 13, where we discuss the role of people’s understanding and anticipation of their own propensity to procrastinate.
- L13. Committing and Uncommitting
The story of procrastination due to hyperbolic discounting is an intriguing one, but it seems to require the procrastinator to be rather dim—or in the words of economists, “naïve.” Owing to hyperbolic discounting, people might realize that they should go on a diet but put off the diet until tomorrow given the steep discount they give to utility of consumption the next day. But when tomorrow arrives, that steep discount is applied to the next day, resulting in putting off the diet one more day. Exactly how many days in a row can people put off their diet before they realize their behavior is preventing them from achieving their goal? Similarly, how often can one put off studying until the last day before the exam without noticing how the behavior affects one’s performance? And if the decision maker does start to recognize the problem of time inconsistency, what would his reaction be?
- L14. Selfishness and Altruism
One of the key features of Homo economicus is an utter disregard for anyone else. Generally, economic models feature actors who choose to maximize their own well-being, be it utility or profit, while ignoring the well-being of others. Such behavior is not required for rationality, but it is often assumed because it makes mathematical models of behavior much simpler. Some of the basic concepts in welfare economics, a study of how economic policies can affect the overall well-being of all actors in an economy, rest upon the assumption of selfish actors.
- L15. Fairness and Psychological Games
One branch of the research on fairness concerns how people react not only to the distribution of outcomes but also to the motivations and perceptions of others. Such conceptions of psychological motivations in games can provide powerful explanations of the behavior commonly observed in laboratory games. These models of behavior also have implications for the real world. Much of work and business is conducted in teams or other groups in which the actions of each individual involved will affect the payouts of all. How teams perceive the diligence of each of their individual members can have a substantial impact on how any one individual will decide on how much effort to put forth. Similarly, firms can use the way they are perceived in the community (e.g., socially conscious vs. greedy) to market their products and services. In each case, how actions are perceived can have a big impact on the behavior of others and ultimately on the profits of firms and well-being of consumers and workers.